A spike in a common benchmark interest rate for commercial real estate lending will increase debt service on many floating-rate loans but isn’t cause for alarm, according to industry observers. Even so, “for some subset of existing borrowers the recent increases are likely to be painful,” says Robert Bach, chief economist at broker Grubb & Ellis in Chicago.

Alarm bells sounded last week when the three-month London interbank offered rate, or LIBOR, shot up nearly 20 basis points in two days to close at 2.91% on Friday, April 18. Many analysts consider the jump to be a correction triggered by the British Bankers’ Association, which is reviewing its method for setting the rate. Three-month LIBOR hit 2.92% this week but fell back to 2.91% on Thursday.

The British Bankers Association sets LIBOR based on the interest that 16 banking institutions charge one another on loans. Earlier this month, analysts suggested some of those banks could be underreporting the interest they charge to downplay increases in their own costs, and those suspicions appear to have triggered last week’s correction.

Most of the commercial real estate industry’s construction loans and other short-term debts are pegged to LIBOR, so the rate spike could affect a wide swath of borrowers. Construction loans outstanding for commercial real estate at the end of 2007, including apartments and condominiums, totaled $358.7 billion, reports Oakland, Calif.-based Foresight Analytics.

The recent increase in LIBOR doesn’t directly present a problem for commercial real estate lenders but is occurring at a difficult time in the economic cycle for their customers with floating-rate debt, according to John Cannon, executive vice president at financial intermediary Capmark Finance Inc. “Borrowers by and large right now can’t pass those costs on to their customers, the tenants,” he says. “The industry has a lot of LIBOR borrowers, so this [rate spike] has a real material impact.”

That impact is even greater than it might have been a year ago, Cannon says, because borrowers are holding onto construction loans and other floating-rate debt longer while they seek permanent financing. Why? Because a lack of liquidity in the market for commercial mortgage-backed securities (CMBS), which was the chief source of permanent financing in recent years, has made fixed-rate loans costlier and more difficult to find and obtain.

If the run-up in LIBOR is sustained over time, borrowers with existing short-term loans may experience difficulty adhering to their budget as debt service increases the demand on the borrower’s cash flow and cash reserves. In the case of a value-add developer using a short-term loan to upgrade an asset, for example, spiking debt service may eat up the budget for some of those improvements. “That has a negative effect on what he can do with other parts of the property,” Cannon says.

In a big-picture sense, however, LIBOR’s 20 basis-point surge isn’t a big deal for the commercial real estate industry, according to Jon Southard, a principal at Boston-based CBRE Torto Wheaton Research. “Certainly not, given that CMBS spreads have moved 100 basis points in a month recently,” Southard says.

Indeed, March 7 spreads on 10-year, AAA-rated CMBS had climbed to 291 basis points over swaps from 93 basis points two months earlier, reaching an all-time high and 10 times spreads a year before. Swap spreads are a premium investors pay when trading floating- for fixed-interest streams, and are added to a long-term interest rate, usually U.S. Treasuries. “On our list of worries, this is pretty far down the list right now given everything else that is happening,” Southard says. “These are crazy times.”

And there is reason to expect LIBOR rates will come down to be closer in line with other short-term rates, such as U.S. Treasuries. A year ago the three-month LIBOR rate was 5.36%, just 52 basis points over the three-month Treasury rate of 4.84%. Today that spread is three times as great at 165 basis points, so a reversion to historical spreads would bring LIBOR down considerably.

“If you take a look at the spreads over a period of time, they’re certainly wider than they traditionally have been,” says Jamie Woodwell, senior director of commercial and multifamily research, Mortgage Bankers Association.

For now, LIBOR remains low enough that floating rate debt is still low and manageable for most commercial real estate borrowers, says Capmark’s Cannon. At 2.91%, today’s three-month LIBOR rate is roughly half the 5.06% it was six months ago. “I don’t think anybody is pushing any panic buttons yet,” he says, “but they’re watching it.”